UNDATED                                                                           Download PDF Version

Risk - Understanding it Better


“It is largely the fluctuations that throw up the bargains and the uncertainty due to fluctuations that prevents other people from taking advantage of them.”
                                                                                                                                                             John Maynard Keynes

Risk management should focus entirely on the potential for a client to suffer a permanent loss of capital which, in turn, will result in their inability to meet their realistic objectives. Therefore avoiding and minimising losses is the most important prerequisite for generating real and realistic returns.

Clarmond prides itself on aligning its own economic interests with those of its clients by eschewing commission driven ‘advice’. We also try very hard to develop a common vocabulary to ensure effective communication and clear understanding of concepts and goals. In this first of a series of investment articles we will discuss how we need to think about risk. In further articles we will discuss how it can be measured and how it can be managed.

The word risk appears in the world press thousands of times every day and is used to express many different concepts. Risk also means different things to different investors. Most importantly, volatility, which is used as a proxy for risk in the investment industry, is not what investors worry about, in our experience investors care most about permanent loss of capital.

Despite the negative connotations of the word, most people understand that ‘risk’ and ‘reward’ are intimately related. The old adage “Nothing ventured nothing gained” underscores the fact that we should not seek to avoid risk altogether. Indeed, we must actively seek out appropriate risks in order to generate returns. However, whereas it may generally be the case that a high return implies a high risk, the reverse, low return equaling low risk, is not necessarily true. For example, investors in Japanese stocks since 1990 and in US large cap stocks since 2000 have endured high risk, in terms of volatility, but negative returns.


To improve our understanding of risk we must do the following:

  1. Distinguish between the volatility that characterizes different investments;

  2. Assess the probability of experiencing a loss or gain of capital after a reasonable length of time; and

  3. Judge the possible impact of such a loss or gain.

Volatility is driven by unpredictable news flow and the complex interaction of buyers and sellers with differing incentives and objectives. Securities such as equities, whose s depend on uncertain long-term cash flows and varying degrees of risk appetite on the part of investors, will inevitably experience volatility.

Over the very long term, more volatile investments have generated higher average returns and many advisors argue that it is necessary to assume this kind of risk to achieve such returns.

However, as we have noted, the outcome of a volatile investment can be negative over periods that exceed the time horizons of most investors.

Common estimates of volatility, such as Standard Deviation or Value at Risk (VAR) can also understate the chance of extreme events. Typically, periods of reduced volatility are punctuated by bursts of much greater fluctuation. So, although it is critical to understand the kind of volatility one can expect from an investment, reducing the concept of risk to a single figure or percentage can lead to spurious accuracy and hence a false sense of security. They are incomplete and misleading measures of risk.

The chart below highlights this very well. The red shaded circles indicate when the Volatility Index (VIX) was at its lowest levels. All these instances marked periods of complacency in the markets but were actually times for extreme caution. Equally, the blue shaded circles represent the highest levels for the VIX; these moments were in fact periods of great opportunity in the equity markets as they presaged substantial recoveries.


Impairment Risks

We will now briefly review the main ‘impairment’ risks. These are the risks which, if wrongly assessed, could lead to a permanent loss of investor capital, leading to a client failing to meet their objectives.

1. Valuation Risk

This is the risk of paying too much for an asset. Therefore to improve the odds of avoiding a permanent loss of capital, as well as achieving a reasonable rate of return over a reasonable period of time, we must always consider the value of an investment compared to historical trends and fundamental indicators.

Overvalued investments often become even more overvalued in the short to medium term; research shows that overvalued markets can take six to seven years to return to fair value. But at some (unpredictable) point a significant drawdown will occur and take prices down to below fair value. 

A good example of valuation risk would be investors who bought technology related investments in 2000; their capital has been permanently damaged (see Nasdaq graph below).


Similarly, undervalued investments may continue to lose value before recovering and will often experience more volatility than overvalued investments. In these cases, markets may rebound strongly only to fall to still lower levels. However, buying assets cheaply will significantly reduce the probability of incurring a significant loss over a reasonable length of time, provided that the portfolio is sufficiently diversified.

2. Business Risk

This is the risk of investing in an asset that has a fundamental problem or flaw. If a portfolio is concentrated in an investment in a particular company, sector, geography, style, fund or fund manager then the client is exposed to unique and unpredictable risks. Even if the probability of experiencing a loss is perceived to be low, if the impact of such a loss is likely to be catastrophic the prudent investor must diversify.

Examples of this sort of risk are, unfortunately, numerous and we list a few below a few investments which, if an investor was too concentrated would have been disastrous:

  1. Enron / Worldcom / Parmalat

  2. Bear Stearns / Lehmans

  3. A Madoff Fund

  4. Asset Based Lending in 2008/9

  5. Russian Debt in the 1990s

This type of risk may be difficult to appreciate when an investment is subject to little or no price volatility because it is not widely traded on a public exchange. For example, an uninsured deposit or loan may appear less risky than an investment in the stock market even though the impact of a loss could be similar or worse. Given the low volatility of these types of investments, portfolio software packages will often allocate large amounts to them.

3. Balance Sheet Risk

This is the risk of not being able to stick with an investment strategy. As we have discussed, volatility cannot necessarily be equated with a broader concept of risk. However, if an investor is unable to endure bouts of volatility, he or she may be forced into selling and thereby incur a permanent loss.

This often occurs with leveraged investors who are forced into selling by anxious creditors. A general rule is that leverage can never make a bad investment good but it can turn a good investment bad. However, investors with insufficient knowledge of what constitutes normal market behaviour may be panicked into selling at the worst possible time.

Investors with other liabilities may also find themselves in a situation where they are forced to raise cash unexpectedly. Recent market experience has reminded us how volatility can be transmitted from one type of investment to another. When cash must be raised and illiquid investments cannot be sold, investors will turn to whatever can be most easily disposed of. 

Market Risks

We have discussed three categories of risk that can result in a permanent loss of capital. However, the word risk is probably used most in conjunction with specific variables, such as:

  1. Inflation Risk

  2. Interest Rate Risk

  3. Currency Risk

  4. Manager Risk

Used in this sense we are simply referring to factors that will affect the current value of an investment and therefore generate volatility. However, the incidence of these risks in a portfolio must be closely monitored because concentrated exposure to any one risk factor will become a form of business risk and could lead to a permanent loss of capital, particularly when valuations reach extreme levels.

Risk and Uncertainty

Professional investors love extreme valuations because the probability of trend reversals is much higher and one can invest with greater degree of certainty. However, these situations are rare and it is a fact of life that most of the time we are faced with uncertainty about the short-term direction of the market. Indeed statistical analysis suggests that market movements are generally unpredictable over a one-year time horizon.

Financial models attempt to calculate risks with mathematical precision so that portfolios can be pushed to the limit to generate higher returns. In real life, however, we must learn to expect the unexpected and design portfolios that are robust enough to withstand unanticipated events as well as being flexible enough to grasp new opportunities.

At Clarmond we are constantly generating scenarios in those areas most likely to throw up surprises, and considering the consequences and investment strategies ahead of time.

Conclusion

Defined as the outcome of an investment, rather than a characteristic such as volatility, we can say that risk is easily understood as a loss of capital. We have reviewed the main ways money can be lost permanently and touched on how to avoid these mistakes.

However, the time frame over which investment outcomes will be judged will vary among clients. Daily peace of mind may also be an important client objective. So, we must also pay great attention to understanding the likely behaviour of different types of investments under different scenarios to ensure that portfolios are properly aligned with expectations. Successful risk management must be measured against the achievement of realistic but individual client objectives.

 

Media

Research Papers


About Clarmond  |  Advisory Complex  |  Media  |  Our Team